Tuesday, May 19, 2009

Don't just stand there, regulate!

Okay, so the novice left-wing attempt at single-factor explanation of our recent crisis might be that de-regulation caused it (the equally wrong novice right-wing attempt would probably blame the CRA or something).

The smarter kids, they'll say we just didn't have the RIGHT regulation. Well, yeah. So... what would that look like? Depends on what you think went wrong...

There are basically two things that had to happen for the melt down to occur:

Investors had to model risk improperly

Those modeling mistakes had to be leveraged, i.e., amplified.

All the focus on (1) is a red herring. Fighting the last war. Arguing about loan fraud enforcement or the CRA is great, but those are the WHAT, not the HOW. The "what" was tulips once, another time it was dot com stocks, another time it was sub-prime mortgages. It's going to be something else next time. I don't see why regulators would be any more likely to see the next bubble coming before the investors. They sure didn't this time around.

Leverage, that second one, that's where the fight should be. There were trillions of leveraged assets involved in the most recent crash. The troubled banks held leveraged obligations measuring huge multiples of their actual assets. Mess up in the millions and the feds probably won't ever notice. Mess up in the trillions and now we're talking about real money.

One way to take prevent excessive leverage is to change accounting rules. Of course it's just such a group of rules that the whole collateralization thing was designed to circumvent. Investors are too clever for their own good, so new regulations will need to avoid actually promoting riskier behavior as investors attempt to engage in creative arbitrage. That might not be impossible, but it will be hard.

Another way to prevent excessive leverage is to take away the money. If your kids keep getting an ice cream headache by scarfing down the chunky-monkey... well, what would you do? Yes, this is the Ron Paul argument (i.e., the Austrian School argument). Banks were taking advantage of low interest rates, borrowing the money that they were investing in this crap. It's never good to have too much money chasing too few solid investments.

Forget ice cream. Easy money is like a flame thrower If you're kids have been operating one of those willy-nilly around the house, do you come up with a complicated set of rules for where they should point it, and when, and at what power, and at what times of day and all that? Or do you just take it away? The Fed and Congress have been falling over themselves to give the kids in the financial sector more propellant than ever before. For the last year or so, the kids have just been hoarding it. For now...

As noted elsewhere, Krugman and his friends worry that if the money isn't easy enough, we'll run into a deflationary liquidity trap. How do we avoid AND avoid blowing another bubble?